No Simple Rules for Debt Risk

Recession-driven pressure on debt losses won’t match that of last decade’s recession, says a new report from Torto Wheaton Research. While the Boston-based research firm — a unit of CB Richard Ellis — has gauged a sharp increase in mortgage delinquencies recently and expects them to continue to rise, it doesn’t anticipate that debt-distress is likely to hit early 1990’s levels.

"Compared to 1992, recent delinquency numbers — except in hotels — seem to indicate an astoundingly successful campaign for mortgage originators to underwrite loans conservatively," writes Jon Southard, Torto Wheaton’s chief economist. But Southard qualifies that observation, admitting that underwriting surely played a part in the "disastrously" high delinquency rates of 1992 — but the real estate market itself contributed mightily to that "perfect storm" of the early 1990’s.

Now, with rents again depressed and vacancies on the rise, what conditions must be met before defaults begin to rise today?

"A key cause of default is when net operating income falls below the debt service. In other words, NOI — and not rents — is the key component to rising defaults," he writes.

In the early 1990’s, the recession capped off a protracted building boom. And office vacancy at the time had been above 16%, where it now stands today, since 1985 (a five-year run). In those five years to 1990, writes Southard, rents were hardly advancing. So when the 1991 recession hit, rent declines impacted NOI immediately, and many loans defaulted. Unlike that scenario, the rent declines of the past two years came on the heels of a steep run-up in rents throughout nearly all markets. Therefore, the current market rents and their declines are not reflective of most existing leases.

"With long leases, the NOI cycle trails behind the rent cycle so that the true test of loan underwriting is yet to be administered," writes Southard. While this can hardly be construed as good news, it would still require three additional years without a recovery for defaults to reach 1992-era levels. "Our most likely forecast is for a recovery to begin at year-end 2003. Still, until NOI turns its corner, risk of default will increase steadily," he writes.